# Best-response functions, best-response curves. Strategic substitutes, strategic complements. Quantity competition, price competition

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1 Strategic Competition: An overview The economics of industry studying activities within an industry. Basic concepts from game theory Competition in the short run Best-response functions, best-response curves Strategic substitutes, strategic complements Quantity competition, price competition Price competition, homogeneous goods: - Discontinuous profit functions - Unique equilibrium: p = MC - The Bertrand paradox Resolving the Bertrand paradox - Product differentiation - Time horizon - Capacity constraints Price competition with capacity constraints Consumer rationing - Efficient rationing, proportional rationing Low capacities: equilibrium with joint price P such that Q(P) = qi. i Tore Nilssen Strategic Competition Lecture 13 Slide 1

2 Capacity competition Stage 1: Firms choose capacities Stage 2: Firms choose prices Outcome as if one-stage competition in quantities Quantity competition The Cournot model n-firm oligopoly - First: first-order condition for a typical firm - Then: invoke symmetry Prices vs. quantities Bertrand or Cournot? Cost function Constant returns to scale: Bertrand Sharply increasing marginal costs: Cournot Measuring concentration The Herfindahl index In a special case, it is proportional to total industry profits Tore Nilssen Strategic Competition Lecture 13 Slide 2

3 Dynamic competition: Tacit collusion Deviation from a collusive price - long-term loss - short-term gain Finite number of periods - no cooperation Trigger strategies Folk theorem Collusion when firms are patient enough (δ high) Collusion when demand varies - May have collusion below monopoly price in highdemand state in order to make collusion sustainable. - Price war during boom? Infrequent interaction Multimarket contact Collusion when other firms prices are unobservable - Low own demand: could be other firms cheating, or low market demand. - Punishment after low demand, but not forever. Tore Nilssen Strategic Competition Lecture 13 Slide 3

4 Dynamic competition: Price rigidities Alternating price setting A discrete price grid Markov strategies: based on payoff relevant information At least two equilibria: - collusion: kinked demand curve - price war and unstable prices: Edgeworth cycle Product differentiation Horizontal differentiation Vertical differentiation Horizontal differentiation The Hotelling model: which product variants are offered in equilibrium? - Consumers heterogeneous with respect to preferences - Transportation costs in product space: a measure of product differentiation - Price competition: Prices are higher when transportation costs are higher - Prices are strategic complements - Equilibrium variants: two-stage game Stage 1: Firms choose product variants Stage 2: Firms choose prices Quadratic transportation costs: product variants in equilibrium are maximally differentiated Social optimum: differentiated, but not max. Equilibrium analysis: direct effect, strategic effect. Tore Nilssen Strategic Competition Lecture 13 Slide 4

5 The circular model: how many product variants are offered in equilibrium? - Two-stage game: Stage 1: Firms enter and spread evenly around the circle Stage 2: price competition. Entry costs Equilibrium: A firm balances gross profits from having a niche in the market against entry costs Social optimum: An entry saves on consumers transportation costs but affects other firms negatively. In equilibrium, too many firms enter. Advertising Informative, persuasive Informative advertising: Firms choose both prices and advertising level. - More advertising: More consumers know about the firm s product - The more firms advertise, the tougher is price competition - Too much advertising in equilibrium? Depends. Tore Nilssen Strategic Competition Lecture 13 Slide 5

6 Vertical differentiation Quality competition Consumers agree on which product variant is the best Consumer heterogeneity with respect to taste for quality Two stage duopoly game: - Stage 1: Firms choose qualities - Stage 2: Firms choose prices - In equilibrium: one high-quality firm, one low-quality firm - Maximum differentiation again, but now in qualities Entry Strategies when confronting an entry threat - Blockading entry - Deterring entry - Accommodating entry Contestability theory - Prices before quantities? Hit-and-run entry. Tore Nilssen Strategic Competition Lecture 13 Slide 6

7 Model of treating an entry threat - Stage 1: Incumbent firm chooses K. Potential entrant makes entry decision. - Stage 2: Either incumbent firm is a monopolist, or the two firms compete by choosing {x 1, x 2 }. - Analysis of stage 2: Comparative statics. - Stage 1: Increase in K has direct and strategic effects. Four possible strategies for the incumbent firm - Top Dog; Puppy Dog; Lean-and-Hungry Look; Fat Cat. - Depending on whether increase in K increases or decreases the incumbent s aggressivity - Depending on whether stage-2 variables are strategic complements or strategic substitutes - Depending on whether the incumbent wants to deter or accommodate entry. Information Perfect Bayesian Equilibrium Strategies and beliefs in equilibrium Price competition with asymmetric information - The uninformed behave as if confronting a virtual, expected type of the other firm Tore Nilssen Strategic Competition Lecture 13 Slide 7

8 Dynamic model: The informed firm may try to affect the uninformed firm s beliefs about its type. - signalling game - Two periods of price competition: First-period prices higher because of the signalling - Entry deterrence: incumbent s price low in order to signal low costs - Welfare effects of asymmetric information: Lower price by the incumbent. Incomplete, symmetric information about demand: Signal-jamming - Each firm wants the other firm to set a high price in period 2. This leads each firm to set a high price in period 1. Incomplete information in the capital market: Dominant firm competes aggressively in order to get the financially weak firm to exit the market. Auctions Various kinds of auctions - Open vs. sealed bids - Open bids: Ascending vs. descending bids - Sealed bids: First price vs. second price Revenue equivalence: Expected revenue for seller is the same in all four kinds of auctions. Tore Nilssen Strategic Competition Lecture 13 Slide 8

9 Bidding behaviour in sealed bid auctions: Second price: bid = valuation. First price: bids are shaded, b < v. Seller s optimum reservation price: parallel story to that of monopoly. Discrimination in auctions: Seller should discriminate in favour of the bad group in order to get higher bids from the good group. Risk averse bidders bid higher than risk neutral ones. Correlated valuations: winner s curse. Vertical relations Contractual relationships producer/retailer - vertical integration - two-part tariff - resale price maintenance - Exclusive dealing, exclusive territories Vertical externality: double marginalization Horizontal externality: can be counteracted by a low wholesale price Tore Nilssen Strategic Competition Lecture 13 Slide 9

10 Vertical foreclosure Essential facility, bottleneck production The Chicago school vs. the foreclosure doctrine - vertical foreclosure is no problem / is a problem. - Chicago school: there is only one monopoly profit A reconciliation: the role of commitment The bottleneck producer cannot get hold of a monopoly profit, because of a commitment problem when contracting with downstream firms Vertical foreclosure is a way of getting around this commitment problem, rather than of extending monopoly power to the downstream market. Thus, vertical foreclosure is potentially harmful. R&D product innovation, process innovation drastic and non-drastic innovations the value of an innovation - to society - to a monopolist - to a competitive firm - to a monopolist facing an entry threat Tore Nilssen Strategic Competition Lecture 13 Slide 10

11 the replacement effect vs. the efficiency effect patent races strategic timing of technology adoption network externalities - excess inertia - strategic compatibility decisions, standardization Mergers A theory of why firms merge: savings on costs that cannot be realized without access to a production that can only be found elsewhere in the industry (the Perry-Porter model). The authorities assessment of a merger proposal - Merger must be profitable. - Therefore it is welfare if the external effect is positive: External effect: combined effect on other (nonmerging) firms and consumers Effect on non-merging firms typically positive, effect on consumers typically negative - In the Perry-Porter model: Effect on non-merging firms is particularly positive if non-merging firms are big. Tore Nilssen Strategic Competition Lecture 13 Slide 11

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